Are Estimates of Rapid Growth in Urban Land Values an Artifact of the Land Residual Model?

62 Pages Posted: 7 Jul 2020 Last revised: 22 Feb 2021

See all articles by John M. Clapp

John M. Clapp

University of Connecticut - Department of Finance

Jeffrey Cohen

University of Connecticut - School of Business

Thies Lindenthal

University of Cambridge

Date Written: January 20, 2020

Abstract

Separating urban land and structure values is important for national accounts and for analysis of house price dynamics. A large part of the literature on urban land valuation uses the land residual method, which relies on the assumption that structures are easily replaced. But urban land value depends on accessibility to nearby land uses, implying that infrastructure and the slowly changing built environment are the most important components of land value. Investments in structures are only slowly reversible, implying that land and structure function as a bundled good whereas land residual theory severs the connection between land value and structure value over time. We develop a simple theoretical model that includes risk – and therefore the option to delay – and compare our model to a nested land residual model before and after a shock to values. Cross-sectionally our model shows that land residual theory overestimates structure value; over time almost all of any change in property value is allocated to land residuals. Data from Maricopa county, AZ, 2012–2018 strongly support option value models when nested within a general model that also includes land residuals. FHFA estimates use entirely different cost estimation methods: our analysis of FHA data suggest that our conclusions generalize to the U.S. as a whole, and that high and rising land value ratios (the “hockey stick” pattern found in the literature) are likely an artifact of the residual model. We further show that construction costs are valued by the housing market, suggesting a new use of the construction cost variable.

Keywords: urban land valuation, option value, land residual method, land leverage, construction costs

JEL Classification: R

Suggested Citation

Clapp, John M. and Cohen, Jeffrey and Lindenthal, Thies, Are Estimates of Rapid Growth in Urban Land Values an Artifact of the Land Residual Model? (January 20, 2020). Available at SSRN: https://ssrn.com/abstract=3618293 or http://dx.doi.org/10.2139/ssrn.3618293

John M. Clapp (Contact Author)

University of Connecticut - Department of Finance ( email )

School of Business
2100 Hillside Road
Storrs, CT 06269
United States
860-983-3685 (Phone)
860-486-0349 (Fax)

Jeffrey Cohen

University of Connecticut - School of Business ( email )

368 Fairfield Road
Storrs, CT 06269-2041
United States

Thies Lindenthal

University of Cambridge ( email )

Trinity Ln
Cambridge, CB2 1TN
United Kingdom

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